Final answer:
Holding a bond until maturity eliminates interest rate risk, ensuring that the holder receives the fixed interest payments and principal back, regardless of market interest rates changes. However, this does not eliminate other forms of risk, such as credit risk and inflation risk.
Step-by-step explanation:
The type of risk that is eliminated if you always hold a bond until maturity is interest rate risk. Interest rate risk arises because the market value of bonds fluctuates with changes in prevailing interest rates. If you purchase a bond when it is issued and hold it until it matures, you are guaranteed to receive the fixed interest payments as well as the return of the bond's face value at maturity, regardless of changes in market interest rates.
For example, if a risk-free bond is issued at $1,000 and pays $80 per year until maturity, you will receive exactly those payments and the initial investment back, even if market interest rates rise to 12%. By holding the bond to maturity, you are not affected by the price volatility that the rate change would cause if you were to sell the bond before it matures.
However, it is essential to understand that holding a bond to maturity does not eliminate other forms of risk, such as credit risk or inflation risk. Credit risk involves the possibility that the bond issuer will default and fail to make the promised payments, and inflation risk refers to the decrease in the purchasing power of money over time, even if the bond's nominal return is fixed and risk-free.